This is just a quick note to point out a useful tool that I ran across while researching our ideal asset allocation. Simply head over to Adviser Online’s Fund Correlation Tool and you can easily determine the correlation between any pair of Vanguard mutual funds.
In case you’re not familiar with the concept of correlation, it’s simply a statistical measure of the degree to which two variables change in concert. A correlation of +1 refers to an increasing linear relationship, whereas a correlation of -1 refers to a decreasing linear relationship. A correlation of zero means that two variables move independently of one another.
While I’m grossly oversimplifying things here, a properly diversified portfolio contains a variety of different security classes with low or even negative correlations. Having this sort of investment mix helps to ensure that when some of your investments are suffering, others are thriving (or at least suffering less), thereby reducing your overall investment risk.
Note that the fund correlation tool reports the correlation coefficient in terms of percentages, so the data points can actually range from -100 to +100.
Large Cap Index vs. Small Cap Index: 89%
Total Stock Market Index vs. Total International Index: 74%
Total Stock Market Index vs. Total Bond Market Index: -17%
Even if you don’t have access to Vanguard funds, this is a great tool for getting a feel for how different asset classes perform relative to one another.
As you can see from above, domestic equities exhibit a relatively strong positive correlation with each other, even when comparing between large and small cap stocks. Likewise, domestic and international equities are reasonably well correlated, though less so than large vs. small cap stocks.
In contrast, stocks and bonds have a slight negative correlation, meaning that increasing in stock values are typically accompanied by decreases in bond prices, and vice versa.
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